Investing For The Common Good: A Sustainable Finance Framework

Finally, this essay outlines how long-term (institutional)investors can build effective coalitions to accelerate thetransformation to sustainable development. While the earlyadopters of sustainability are primarily based in Europe,major players in North America and Asia have also joinedthe emerging coalitions for sustainable finance. Sustainableinvesting has thus become a global force. In this essay, wedevelop guidelines for sustainable finance, which are summarised in Box 1.Box 1: Guidelines for sustainable financeSocial and environmental externalities are by their naturenot incorporated in the decisions taken by companies andinvestors. As most externalities play out in the medium tolong term, the problem is aggravated by the short horizonexecutives and investors work to. Moreover, the efficient markets hypothesis, which states that stock prices incorporate allrelevant information and thus reflect the fundamental valueof the firm, reinforces the focus on stock price as a centralperformance measure for executive and investor performance.This essay develops the following guidelines to governsustainable finance:Company perspective Move from shareholder to stakeholder value approach,whereby a company balances the interests of all its stakeholders: customers, employees, suppliers, shareholdersand the community.More broadly, corporates should strive for long-term11

value creation for the common good (ie what is sharedand beneficial for all or most members of a givencommunity).Lengthening executive and investors’ horizons To counter short-termism, executive and investor horizons should be aligned to the long term.On the executive side, a more long-term orientedreporting structure (moving away from quarterlyreporting) and pay structure for executives (eg deferredrewards and clawback provisions) would reduce shorttermism.More generally, integrated reporting by companies facilitates social and environmental transparency and thusincreases the accountability of executives.On the investment side, a more long-term investmentperformance horizon (moving away from quarterlybenchmarking) and incentives for long-term investors (egloyalty shares) would promote long-term investment.Engagement To become a force for long-term value creation, long-term(institutional) investors should build investor coalitions tocooperate on engagement with corporates on social andenvironmental issues.Market efficiency and liquidity 12Raise awareness of alternative theories of marketefficiency.The dominant view of liquidity (the degree to which anasset can be quickly bought or sold in the market without

affecting the asset’s price) favours listed securities and isbased on the efficient markets hypothesis.An alternative view is the adaptive markets hypothesis, which implies that the degree of market efficiencydepends on an evolutionary model of individuals adapting to a changing environment. That can explain whynew risks, such as environmental risks, are not (yet) fullypriced in.Supervisory treatment Reduce the supervisory bias towards favouring ‘liquid’investments (which are listed) and allow for ‘buy andhold’ investments. An example is the introduction of sustainable retail investment funds, based on sustainabilitycriteria (instead of transferability).Financial institutions should be stress-tested to identifyoverexposure to and concentration in carbon-intensiveassets. These carbon stress tests make use of variousclimate scenarios, including the adverse scenario of lateadjustment resulting in a ‘hard landing’, and have a longhorizon over which adverse events could occur.13

2 SUSTAINABILITY CHALLENGES2.1 Environmental challengesThere is increasing evidence that human activities areaffecting the Earth system, threatening the planet’s futureliveability. The planetary boundaries framework of Steffen etal (2015) defines a safe operating space for humanity withinthe boundaries of nine productive ecological capacities of theplanet. The framework is based on the intrinsic biophysicalprocesses that regulate the stability of the Earth system at theplanetary scale. The green zone in Figure 1 is the safe operating space, yellow represents the zone of uncertainty (increasing risk) and red indicates the zone of high risk.Applying the precautionary principle, the planetaryboundary itself lies at the intersection of the green and yellowzones. To illustrate how the framework works, we look at thecontrol variable for climate change, the atmospheric concentration of greenhouse gases. The zone of uncertainty rangesfrom 350 to 450 parts per million (ppm) of carbon dioxide.At 399 ppm in 2015, we have already crossed the planetaryboundary of 350 ppm. The upper limit of 450 ppm is consistent with the goal (at a fair chance of 66 percent) to limitglobal warming to 2o Celsius above the pre-industrial leveland lies at the intersection of the yellow and red zones.

Figure 1: The planetary boundariesSource: Reproduced with permission from Steffen et al (2015).The current linear production and consumption system isbased on extraction of raw materials (take), processing intoproducts (make), consumption (use) and disposal (waste).Traditional business models centred on a linear systemassume the ongoing availability of unlimited and cheapnatural resources. This is increasingly risky because non-renewable resources, such as fossil fuels, minerals and metals,are increasingly under pressure, while potentially renewableresources, such as water, forests and fisheries, are declining intheir extent and regenerative capacity.With this linear economic system, we are crossing planetary boundaries beyond which human activities might destabilise the Earth system. In particular, the planetary boundaries of climate change, land-system change, biodiversity loss15

(terrestrial and marine) and biochemical flows (nitrogen andphosphorus, mainly because of intensive agricultural practices) have been crossed (see Figure 1). A timely transformation towards an economy based on sustainable productionand consumption, including use of renewable energy andreuse of materials, can mitigate these risks to the stability ofthe Earth system.2.2 Social foundationsHuman rights provide the essential social foundation for allpeople to lead lives of dignity and opportunity. Human rightsnorms assert the fundamental moral claim each person hasto life’s essentials, such as food, water, health care, education,freedom of expression, political participation and personalsecurity. In the run-up to the 2012 Rio 20 Conference on Sustainable Development, the social foundations were definedas the eleven top social priorities, grouped into three clusters,focused on enabling people to be: 1) well: through foodsecurity, adequate income, improved water and sanitationand health care; 2) productive: through education, decentwork, modern energy services and resilience to shocks; and3) empowered: through gender equality, social equity andhaving political voice (Raworth, 2012).While these social foundations only set out the minimumof every human’s claims, sustainable development envisionspeople and communities prospering beyond this, leadinglives of creativity and fulfilment. Sustainable developmentcombines the concept of planetary boundaries with thecomplementary concept of social foundations or boundaries. Sustainable development means that current and futuregenerations have the resources needed, such as food, water,16

health care and energy, without stressing the Earth systemprocesses (Raworth, 2012).But many people still live below the social foundations ofno hunger, no poverty (a minimum income of 1.25 a day),access to education and access to clean cooking facilities.More broadly, political participation, which is the right ofpeople to be involved in decisions that affect them, is a basicvalue of society. The UN’s Universal Declaration of HumanRights states that “recognition of the inherent dignity and ofthe equal and inalienable rights of all members of the humanfamily is the foundation of freedom, justice and peace inthe world”. Human rights are an important social foundation. Next, decent work can lift communities out of povertyand underpins human security and social peace. The 2030Agenda for Sustainable Development (United Nations, 2015;see below) places decent work for all people at the heart ofpolicies for sustainable and inclusive growth and development. Decent work has several aspects: a basic living income(which depends on a country’s basic living basket), nodiscrimination (eg on the basis of gender, race or religion), nochild labour, health and safety and freedom of association.From a societal perspective, it is important for businessto respect these social foundations and to ban underpayment, child labour and human right violations, which are stillhappening in developing countries. A case in point is the useof child labour in factories in developing countries producingconsumer goods, like clothes and shoes, to be sold by multinational companies in developed countries. These factoriesoften lack basic worker safety features (Box 3). Another example is the violations of the human rights of indigenous people,often in combination with land degradation and pollution, by17

extractive companies in the exploration and exploitation offossil fuels, minerals and other raw materials.To highlight the tension between unbridled economicgrowth and sustainable development, we provide twoexamples. Box 2 describes the Deepwater Horizon oil spillin the Gulf of Mexico. Box 3 shows the impact of the collapse of a factory building in Bangladesh. These exampleshave in common underinvestment in safety to increaseshort-term profits.Box 2: The Deepwater Horizon oil spillThe oil spill from the Deepwater Horizon drilling platformbegan on 20 April 2010, in the British Petroleum-operatedMacondo Prospect in the Gulf of Mexico. An explosion onthe drilling rig killed eleven workers and led to the largestaccidental marine oil spill in the history of the petroleumindustry. The US Government estimated the total dischargeat 4.9 million barrels. After several failed efforts to contain theflow, the well was declared sealed on 19 September 2010.A massive response ensued to protect beaches, wetlandsand estuaries from the spreading oil utilising skimmerships, floating booms, controlled burns and oil dispersant.Oil clean-up crews worked on 55 miles of the Louisianashoreline until 2013. Oil was found as far from the Deepwater Horizon site as the waters off the Florida Panhandle andTampa Bay, where oil and dispersant mixture was embedded in the sand. The months-long spill, along with adverseeffects from the response and clean-up activities, causedextensive damage to marine and wildlife habitats and thefishing and tourism industries.18

Numerous investigations explored the causes of theexplosion and record-setting spill. Notably, the US government’s September 2011 report pointed to defective cementon the well, faulting mostly BP, but also rig operator Transocean and contractor Halliburton. Earlier in 2011, a NationalCommission (2011) likewise blamed BP and its partners fora series of cost-cutting decisions and an inadequate safetysystem, but also concluded that the spill resulted from“systemic” root causes and that without “significant reformin both industry practices and government policies, mightwell recur”.19

Box 3: Rana Plaza factory collapseThe Rana Plaza collapse was a disastrous structural failureof an eight-storey commercial building that occurred on 24April 2013 in Bangladesh. The collapse of the building caused1,129 deaths, while approximately 2,500 injured people wererescued from the building alive. It is considered the deadliestgarment-factory accident in history and the deadliest accidental structural failure in modern human history.The building contained clothing factories, a bank,apartments, and several shops. The shops and the bank onthe lower floors were immediately closed after cracks werediscovered in the building. The building’s owners ignoredwarnings to evacuate the building after cracks in the structureappeared the day before the collapse. Garment workers, earning 38 a month, were ordered to return the following day,and the building collapsed during the morning rush-hour.The factories manufactured clothing for brands includingBenetton, Bonmarché, the Children’s Place, El Corte Inglés,Joe Fresh, Monsoon Accessorize, Mango, Matalan, Primarkand Walmart.20

2.3 Sustainable developmentTo guide the transformation towards a sustainable and inclusive economy, the United Nations has developed the 2030Agenda for Sustainable Development (UN, 2015). The 17 UNSustainable Development Goals are intended to stimulateaction over the 2015-30 period in areas of critical importancefor humanity and the planet (see Box 4 for an overview). Tofacilitate implementation, the 17 high level goals are brokendown into 169 targets (see inabledevelopmentgoals). The UN Sustainable Development Goals address challenges at the levelsof the economy, society and the environment (or biosphere).Figure 2 illustrates the three levels and the rankingbetween them. A liveable planet is a precondition (foundation) for humankind to thrive. Next, we need a cohesive andinclusive society to organise production and consumption inorder to ensure enduring prosperity for all. In their seminalbook Why nations fail, Acemoglu and Robinson (2012) showthat political institutions that promote inclusiveness generateprosperity. Inclusiveness allows everyone to participate ineconomic opportunities. Next, there can be resource conflicts: unequal communities might disagree over how to share(and finance) public goods. These conflicts, in turn, breaksocial ties and undermine the formation of trust and socialcohesion (Barone and Mocetti, 2016).21

Box 4: UN Sustainable Development Goals (Source: UN, 2015)The United Nations has developed 17 Sustainable Development Goals (SDGs) as part of the 2030 SustainableDevelopment Agenda. Following Rockström and Sukhdev(2015), we classify the SDGs according to the levels of theeconomy, the society and the environment. Nevertheless,we stress that the SDGs are interrelated. A case in pointis the move to sustainable consumption and production(economic goal 12) and sustainable cities (societal goal11), which are instrumental to combat climate change(environmental goal 13).Economic goals Goal 8: Promote sustained, inclusive and sustainableeconomic growth, full and productive employment anddecent work for allGoal 9: Build resilient infrastructure, promote inclusiveand sustainable industrialisation and foster innovationGoal 10: Reduce inequality within and among countriesGoal 12: Ensure sustainable consumption and productionpatternsSocietal goals 22Goal 1: End poverty in all its forms everywhereGoal 2: End hunger, achieve food security and improvednutrition and promote sustainable agricultureGoal 3: Ensure healthy lives and promote well-being forall at all agesGoal 4: Ensure inclusive and equitable quality educationand promote lifelong learning opportunities for all

Goal 5: Achieve gender equality and empower all womenand girlsGoal 7: Ensure access to affordable, reliable, sustainableand modern energy for allGoal 11: Make cities and human settlements inclusive,safe, resilient and sustainableGoal 16: Promote peaceful and inclusive societies forsustainable development, provide access to justice for alland build effective, accountable and inclusive institutionsat all levelsEnvironmental goals Goal 6: Ensure availability and sustainable managementof water and sanitation for allGoal 13: Take urgent action to combat climate change andits impactsGoal 14: Conserve and sustainably use the oceans, seasand marine resources for sustainable developmentGoal 15: Protect, restore and promote sustainable useof terrestrial ecosystems, sustainably manage forests,combat desertification, and halt and reverse landdegradation and halt biodiversity lossOverall goal Goal 17: Strengthen the means of implementation andrevitalise the Global Partnership for Sustainable Development23

Figure 2: Sustainable development challenges at different levelsEconomySocietyEnvironmentSource: Adapted from Rockström and Sukhdev (2015).While it is tempting to start working on partial solutionsat each level, the environmental, societal and economicchallenges are interlinked. It is important to embrace anintegrated social-ecological system perspective (Norström etal, 2014). Such an integrated system perspective highlightsthe dynamics that such systems entail, including the role ofecosystems in sustaining human wellbeing, cross-systeminteractions and uncertain thresholds.A well-known example of cross-system interaction is thelinear production of consumption goods at the lowest costcontributing to ‘economic growth’, while depleting naturalresources, using child labour and producing carbon emissions and other waste2.Another cross-system interaction is global warmingleading to more and more-intense disasters, such as storms,flooding and droughts. The low and middle-income countries2 We use carbon emissions as shorthand for greenhouse gas emissions, whichinclude carbon dioxide (CO2), methane (CH4) and nitrous oxide (N2O).24

around the equator are especially vulnerable to these extremeweather events, which could damage a large part of theirproduction capacity. The temporary loss of tax revenues andincrease in expenditures to reconstruct factories and infrastructure might put vulnerable countries into a downwardfiscal and macro-economic spiral with an analogous increasein poverty (Schoenmaker and Zachmann, 2015). Social andenvironmental issues are thus interconnected, whereby thepoor in society are more dependent on ecological servicesand are less well protected against ecological hazards.An example of an uncertain threshold combined withfeedback dynamics is the melting threshold of the Greenlandice sheet. New research has found that it is more vulnerableto global warming than previously thought. Robinson, Calovand Ganopolski (2012) calculate that a 0.9 C global temperature rise from today’s levels could lead the Greenland icesheet to melt completely. Such melting would create furtherclimate feedbacks in the Earth ecosystem, because the melting of the ice cap could increase the pace of global warming(by reducing the refraction of solar radiation, which is 80percent from ice, compared with 30 percent from bare earthand 7 percent from the sea) and of rising sea levels. Thesefeedback mechanisms are examples of tipping points

Finally, finance is good at pricing risk for valuation purposes and can thus help to deal with the inherent uncertainty about environmental issues, such as the impact of carbon emissions on climate change. Finance and sustainability both look to the future. Table 1: A framework for sustainable finance Sustainable finance typology Value created